Natural Resources Stocks: Set to Rebound?

It's time to check out the coal, steel and mining sectors

Don’t look now, but the most beaten-up natural resources stocks may finally be gaining some traction. Even as the S&P 500 has surged more than 23% during the past 12 months, just about any stock linked to Chinese industrial demand — including coal, steel and mining shares — has been left in the dust on concerns that China’s economy is headed for a hard landing.

Still, a look at the charts shows that these underperformers have largely held steady near their lows for five months now, which may indicate that better days are on the horizon.

The Market Vectors-Coal ETF (NYSE:KOL) is a prime example of this stabilization. While the long-term chart is ugly …

… the six-month chart tells a different story:

The charts of Market Vectors Steel Index Fund (NYSE:SLX), Alcoa (NYSE:AA), and the iron ore producer Vale (NYSE:VALE) have also exhibited steadying since the early summer (next three charts, below).

Perhaps most notably, these charts show a similar pattern: a long-term basing formation accompanied by 200-day moving averages that are flattening out or beginning to rise. If these stocks begin to rise above their 200s, it will mark a significant sea change for a group that has lagged for almost two years now.

China: Hard Landing or Not?

Whether they can take out this key technical level remains dependent from the news flow out of China. The primary reason why these stocks have underperformed by such a wide margin is slowing Chinese demand and the ongoing concerns that the country’s economy is headed for a “hard landing.” China’s growth, while still much higher than that of the developed world, indeed has slowed to a rate just over half of what it registered in 2007 — and that’s if you believe the numbers.

In addition, persistent stories about China’s completed — yet empty — cities have served as a potent symbol that it may be suffering the same type of overcapacity that plagued the region’s smaller countries during the mid-1990s.

However, the fact that these stocks have flat-lined even as the Chinese economy has remained sluggish may indicate that the environment of slowing growth has been fully discounted into share prices, even if a hard landing hasn’t. But just last week, the director of the IMF’s Asia/Pacific segment said the odds of a hard landing were “remote” and that “China is not having a hard landing. The numbers are clearly recognizing that China will grow this year.”

Indeed, the most recent round of data released over the weekend painted a picture of a still-healthy economy, and last night’s Chinese GDP figure came in at 7.4% — in line with expectations. Perhaps most important was the reported inflation rate of 1.9%, which provides more latitude for Beijing to pursue stimulative policies. With low inflation and slowing growth, the possibility of new policy initiatives grows with each passing week.

The improving sentiment is illustrated by the strong recent gains for diversified miners such as Freeport McMoRan (NYSE:FCX) and BHP Billiton (NYSE:BHP), which are up substantially from their mid-summer lows. China itself, as gauged by iShares Trust FTSE China 25 Index Fund (NYSE:FXI), has broken out to five-month highs even as the coal, steel and other China-related cyclical names have not.

What’s Next, and What to Watch

Investors who wait for confirmation of a revival in Chinese growth to buy the materials sector’s laggards may find themselves late to the party. Because stock performance is typically forward-looking by six to 12 months, it’s likely we’ll see a recovery in these names far before the news flow begins to turn positive.

As a result, it may be time to take another look at these names. Cyclical materials names are risky, to be sure. But they’re also cheap, they’re one of the few market sectors that’s truly beaten up and in many cases they offer attractive dividends.

Tight stops are a must, however. An acceleration of the downturn in China will undoubtedly knee-cap anyone who ventures into the cyclicals without the appropriate degree of caution. And if the past two years have taught us anything, it’s that the headlines have an infinite capacity to produce negative surprises.

There’s also a broader implication if these names manage to break out of the upper end of their range: It could be an indication of a shift in market leadership. Technology, health care and consumer stocks have shouldered a heavy burden in recent months, lifting the broader market higher even as materials, energy and industrials have failed to recapture their previous highs.

If coal, steel and other China-sensitive sectors were to begin clawing their way out of the current range, it would signal a healthy rotation and could help limit downside in the market.

For an indication of where the cyclicals are headed next, it may pay to keep an eye on the 10-year Treasury. Its yield has been a leading indicator for this group, and it, too, has traded in a range in recent months. Notably, it closed just short of its 200-day on Wednesday.

While the 10-year yield has flirted with a move above this resistance line on multiple occasions during the past year, it so far has been unable to break through. If it manages to do so in the days and weeks ahead, it may be one of the clearest signs yet that it’s time to bet on the materials’ sector’s most depressed stocks.